IMN US CLOs and leveraged loans conference recap

Opportunities in a deteriorating macro environment were a strong focus of Information Management Network’s 12th Annual Investors Conference on CLOs & Leveraged Loans in New York, on 17 and 18 April.

This is a credit pickers’ market, several speakers noted. New issuance is not expected to drop, despite the many headwinds. A few panellists predicted a total amount of $100bn, others thought that volumes could even be above that. In any case, US issuance levels will be high by historic standards, even if some buyers of triple-A rated notes (most notably large US banks) have been on the sidelines.

The outlook for the CLO market was viewed as generally positive, based on current forecasts and as long as the recession in the US turns out to be mild, as most people expect. In this mild scenario, CLOs should be fine even if some dispersion between deals and managers will be seen. CLOs have survived much worse events than the recent bank failures, Paul Travers, managing director at Sycamore Tree Capital Partners, said.

Speaking on Monday’s “Through the Looking Glass: CLO & Leverage Loan Market Outlook” panel, S&P’s Minesh Patel, a senior director of US Corporate Ratings at S&P Global, noted that a “short and shallow contraction” remains the base-case scenario for the US economy but the “risk of a hard landing is still out there”. The key concern relates to issuers rated B-minus, especially those operating in sectors that are already showing some early signs of stress (notably healthcare service providers and media & entertainment).

“Defaults will go up, even if a recession does not materialise,” said Amir Vardi, Managing Director, Portfolio Manager, Head of Structured Credit at CSAM’s Credit Investments Group. Free money propped up weaker businesses, which had idiosyncratic issues. Some may default due to tighter credit conditions, rather than solely due to higher interest rates, he explained on the “Investor Insights: Opportunities Across the Capital Stack” panel.

Opportunities
From a CLO investor perspective, this is a great time to finally see what CLO managers can do through a cycle, said Edwin Wilches, a portfolio manager at PGIM on the Through the Looking Glass panel. But he also made the point that given wide range of market possible market outcomes it is not too easy to figure out how deep the expected recession will be and how it will impact CLOs as timing is everything.

The increase in underlying assets rated triple-C, as a consequence of the expected downgrades of single-B minus issuers, and higher defaults would suggest that around 15% of assets backing CLO portfolios could be in some sort of stress, “which doesn’t feel great”, he told conference attendees. He also stressed that CLOs are not forced to sell triple-C rated assets, this is more a psychological thing – window dressing.

According to Matthew Layton, partner at Pearl Diver Capital, concerns over growing default risks are understandable, but people should bear in mind that 95-97% of issuers will be fine and that CLOs are designed to withstand a mild recession. He pointed to the many opportunities that arise in such a market, notably through amend & extends, which allow CLO arrangers to pick additional spread which then flows into the CLO structure.

While it can be difficult to make the case for sub notes in the primary market, CLO investors can find double-B rated bonds in the secondary market at very attractive yields, at DMs of 1,000 DM. In his view, double-B close to the end of the reinvestment period are particularly attractive. “There are many ways to invest in this market, you need to be fluid with your allocation, but there are strong returns to be made,” he said.

In terms of relative value, PGIM’s Wilches noted that CLOs in the secondary market feel cheap, but he doesn’t find triple-As as compelling as they have been, given that asset classes such as CMBS also look very compelling. He agreed with the other panellists that many opportunities are available, noting that there may be more resets than people tend to assume – which could produce a good pull to par for some secondary bonds that trade at discounts.

On Monday’s “Investors’ Insights” panel, CLOs were also viewed as very attractive, but again with some doubts over CMBS – they may be cheaper, but this may also be due to the greater risk associated with the real estate market.

Pramit Mukherjee, senior investment manager at Legal & General thinks the top of the capital structure is an attractive place to be given current spreads and structural protections, even if spreads have been coming in recently. At the triple-B level it is more credit and manager dependent and caution is warranted, but in his view the market is appropriately pricing the risk at the mezzanine IG level.

Non-investment grade bonds would logically warrant even more caution, but many panellists pointed to the risk/return.

Speaking on Tuesday’s “Clash of the Titans: CLO Debt vs Equity” panel, Gretchen Lam, a senior portfolio manager at Octagon Credit Investors, commented that in the course of history, there have been “very few periods of time when CLO double-B tranches generated yields in the double digits, while offering at the same time real price convexity and additional upside potential."

In contrast, the economics of the equity of some new issues do not seem to make sense, another speaker on this panel said.

ESG
Interest in ESG is seemingly on the rise amongst CLO managers in the US despite persistent definition and regulation limitations. While the focus for market participants is firmly with the worsening macroeconomic environment, panellists in the “Methodology to the Madness: Applications of ESG to CLOs” session did share some surprising optimism for the future.

“The EU is further ahead of the US, but the US is slowly but surely catching up in both investor appetite and demand,” explains Diana Li, manager at PWC. “The key differentiating factor here is that the EU ESG market has been driven by regulatory support, versus in the US where we don’t necessarily have regulatory guidance such as the SFDR.”

However, the mood in the room highlighted a significant boost in market awareness and understanding of ESG, as the number of hands up when asked who was familiar with SFDR in the room shocked the panel.

That said. “Many US managers are asking about adding CLO sleeves into their funds that are classified as article 8 or 9, and although these sleeves are not necessarily in the same criteria as general funds are just yet, there has been a lot of interest in this space,” noted Li

“About 40% of outstanding CLOs in the US have some notion of a negative ESG screening – although these are limited and set at a high threshold – versus about 75% in Europe,” added Dagmara Michalzuk, principal and portfolio manager at Tetragon Credit Partners.

“I think the market will eventually go towards more positive metrics,” agreed Peter Sallerson, senior director at Moody’s Analytics. “But because people have difference of opinions, it’s easier to know what’s bad, and harder to know what’s good.”

“The problem with positive screening is that manager A does one criteria, and manager B does something different that is not as well known to the investors, so it is harder to compare deal A and deal B because you’re measuring it by different metrics,” added Sallerson

However, the panel did agree that however ESG progresses in the US CLO market, having clearer definitions for what ‘good’ and ‘bad’ are will likely impact on CLO pricing – regardless of interest in ESG. The panel agreed that data is also essential for preventing greenwashing in US ESG CLOs, as Li stated: “It all starts with integration of ESG in your daily deal processes, and that starts at the beginning of deal initiation and drafting, all the way to deal close.”

“There’s a big trend in the article 8 and 9 fund space in the Europe and US of the de-classification of funds from article 9 to 8 and article 8 to 6 – because they don’t think they would be able to meet the higher criteria when it comes time for the regulator to review them – that’s fundamentally greenwashing,” said Li. “This is a big reputational risk for a manager, so they are being cautious this year as they go into the first reporting cycle, and setting themselves up for success next year.”

Sallerson continued: “Even if you have all the data, because different things are important in different industries, you need something to normalise that to try and compare. 75% of the information in the CLO market is private – most CLO managers have access to this information, but they can’t share it – they instead have their own internal credit analysis.”

“What would be better, and what we and others can do, is take all that private information, all the other information that’s available, and score the deals to collateral of a common standard – so they have an E, an S and a G score for every piece of collateral. For a CLO it would just be an average of the collateral,” Sallerson explained.

“You need some commonality to be able to trade on this. You need the market to provide common standards, it could be from us, it could be from a host of other people – but you need common standards to compare deals A and B, and trade it and decipher what you do like from what you don’t like,” he added.

Ultimately, the panel still see a long road ahead for standardisation across ESG in the US CLO market, despite efforts towards convergence in the US with European ESG regulation. As Michalzuk concluded: “Rome wasn’t built in a day – there’s a lot more work to be done.”

Manager tiering
An estimated 28 new managers entered the CLO market from 2019 through the end of last year, according to speakers on the “Thinning the Herd: Manager Tiering & Consolidation Trends” panel. However, they agreed that everyone’s definition of what constitutes a ‘new’ CLO manager is slightly different.

Angela Best, director and portfolio manager, CLOs at MetLife Investment Management, suggested that new entrants could comprise an individual that is looking to monetise their investment over the next couple of years with significant backing. Alternatively, they could be part of a larger insurance company or asset manager that is expanding into the CLO market as a natural extension of its business. Then there are those backed by a hedge fund or some other firm that is looking to seed and grow with a certain manager.

She pointed out that technology and headcount is expensive, presenting a high barrier to entry. However, new entrants bring the ability to be nimble and adopt a different manager style or strategy that adds diversification to an investor’s portfolio.

Paul Travers, md at Sycamore Tree Capital Partners, said he’s often asked why he’d start a CLO business now. One reason is that a CLO business can quickly grow from zero to a couple of billion dollars in a few years and those same skills can be used to run SMAs or loan deals. Another reason is that it enables a manager to build a platform to invest in CLO debt or equity as well.

The performance of new managers will generally be better than average - in the first few years, at least - because there are no legacy deals in their portfolios, according to Conor O'Toole, global head of CLO research at Deutsche Bank. “Obviously, there’s quite a lot of dispersion and credit section is key,” he explained.

He added that while a larger manager tends to have better access to collateral, smaller managers are typically able to get in and out of positions fairly quickly when necessary.

In terms of CLO manager tiering, Best indicated that the market has a tier one, two and three schematic, reflecting performance, size and liquidity. Generally, tier one managers command the tightest prints, currently at 183bp-185bp at the triple-A level. In comparison, tier two managers print at around 200bp and tier three above that.

“Typically, a tier three manager has a limited track record or no track record,” observed Best. “I don't necessarily think a new manager is automatically in tier three. But given the fact that investors want to ensure that it is going to be programmatic and that they just don't have the scale yet, they’re going to demand some spread pick-up.”

O'Toole noted that some migration can occur between tiers, noting that when a few top tier managers have underperformed, their pricing widened as the market reassessed them. Best added that it can also go the other way, with tier three managers progressing to tier two or one over time.

The panellists also agreed that the market is ripe for further consolidation among CLO managers, partially to benefit from the variable cashflows generated by asset management fees and partially because it is hard to raise third-party equity. Another advantage is that smaller managers can price better post-acquisition.

But Best warned that manager M&A can be impactful to portfolios, in terms of overall diversification and exposure to a particular issuer. “You really have to think about portfolio overlap: we've observed that following an acquisition, over let's say six months, those portfolios start to converge. So, you're going to see some par burn and higher trading activity, in order to save some overall P&L,” she explained.

She concluded: “Performance matters: we want to see managers staying true to whatever style it is that they’ve communicated as a manager. If that is the case, then performance will follow, they can achieve scale and they're going to attract liquidity.”

Technology
The “'iCLO': Technology, Innovation, and the Future of CLOs” session found plenty of common ground and positivity about the near- and long-term for the markets’ relationship with technology. However, the complex nature of CLOs and leveraged loans will inevitably mean the technological progress will lag more vanilla markets.

Consensus was immediately reached one key aspect – now is an unprecedented and exciting time in the CLO and leveraged loans technology space. Not only have the markets themselves grown dramatically in recent years in terms of both volumes and participants, but technology has advanced significantly too.

First, there is there is a lot more acceptance for technology and quantitative tools to leverage core credit expertise, combined with a greater understanding of the need to resolve some of the markets complexities before regulators demand it and that technology can help there.

Second, and perhaps even more important computing power has advanced exponentially in recent times. Calculation speeds have finally caught up to make vital tools and processes both new and old truly viable.

As Joseph Squeri, Partner, CIO & COO at Exos Financial, observed: “The velocity as the volume of secondary CLO trading will increase with the electronic trading venues that are coming to market. The ability to actually get tradable prices that are in the marketplace is really making it way more exciting to us not only as an architect of building platforms, but also as portfolio managers and traders because you know you will potentially be able to add additional alpha to your returns.”

“I've been in the industry for 20 years or so and it seems like we've been talking about the same things over and over again, but I think this time we do have an opportunity,” concurred Michael Pusateri, Chief Executive Officer at Siepe. “Thanks to co-efficient markets, Octaura, Versana and some of the things that are happening in the marketplace to help streamline and make data more available in a more consistent format, it’s a chance to make all of our lives easier, especially as it comes to reporting back to our investors.”

Artificial Intelligence (AI) inevitably came up in the conversation and while it was agreed that it would prove an increasingly useful tool, the specific requirements of the leveraged loan and CLO markets surrounding their complexity and the need for confidentiality mean these markets are unlikely to be at the forefront of AI development. Similarly, the bespoke nature of the markets slows the use of technology more broadly.

The panellists agreed that at some point the loan and CLO markets need to decide what is really necessary in terms of their customised nature and what is simply customisation for the sake of it. Consequently, there will be moves to increasing standardisation which will ultimately both benefit the broader market and those building technological systems.

However, such moves won’t be without their difficulties, according to Sean Kelley, Head of CLO Data Analytics & Research at U.S. Bank. “The loan asset class is nimble for a reason – it fits a need in the capital structure and it will always be nimble and therefore technology will always be harder to develop in the loan asset class than other asset classes,” he said. “It will always have an outsider and bespoke aspect to it, but I think that's what makes the loan asset class special and an asset class that solves a need.”

Manager matters
Post-reinvestment criteria, WAL tests, prepayments and triple-C buckets were hot topics throughout the two-day conference, but particularly so on the CLO Manager Roundtable.

CLO managers were keen to remind conference attendees that their role was to pick the right credits and avoid the bad ones. However, this can be tricky in the current market. CLO managers fundamentally try to understand what the right value is and what the right attachment point is for the credit that they are buying, a speaker said.

Recoveries can be expected to be lower and this is very difficult to price, another panellist said. CLO managers have to work using a series of assumptions (on interest rates scenarios, EBITDA etc), model what happens in a worst-case scenario, work out what is permissible in the documentation. In these circumstances, modelling causes headaches.

Managing transactions that are exiting or will soon exit their reinvestment period was another key theme. One panellist said that the market has realised that the typical refis and resets seen in the past will not be happening. The trick now is to try to get ahead of that and extend out some of the maturities in the existing portfolios, he noted.

Dealing with reinvestments and asset sales has implications in terms of portfolio management, but pauses some operational challenges too. “Somebody has to keep track of these prepayments or sale along with the characteristics of those loans or bonds,” one speaker said, noting that this is probably most likely a middle office and back office type of process.

Another big question mark is what will happen when some triple-A tranches start to amortise and where the money goes.

The new issue market remains open, but with little involvement of third-party equity investors. In an afternoon panel, one investor said that the economics of the equity of some new issues do not seem to make sense.

Managers with captive funds are obviously in a much stronger position. But having some visibility on funding of the equity is vital for all managers, notably those looking to enter the market and establish themselves. On Monday Paul Travers, managing director at Sycamore Tree Capital Partners, explained why it is so important to provide investors with some visibility over the placement of the equity. “New issue CLO debt investors gain confidence when they know where the equity is coming from and they believe there will be continued future interest in a manager’s CLO equity,” he told conference attendees.

Bifurcation
The bifurcation of the loan market was a key concern – bifurcation between loans that all the players like and those that are shunned. Downgrades are expected to pick up soon, which will likely lead to some WARF tests being breached and triple-C baskets going above the limit. “I think that's going to have a big impact on secondary trading" and continue to exacerbate the bifurcation, a panellist said.

Some credits are likely to continue to trade at strong levels, even in a recessionary environment, but some weaker credits will come under pressure and their price could fall significantly. CLO managers will have to navigate this, when they try to manage their triple-C bucket and the excess triple-Cs. If loan prices hold up well or rebound quickly, the situation will not be too bad, a panellist commented.

However, a conference attendee commented on the sidelines of the event that this could potentially be quite messy. If loan prices slowly drift wider (without a sharp rebound like the one seen at the time of the COVID crisis), CLO managers may well try to stay below the 7.5% limit by selling the assets that attract the strongest bids and keep weaker names in their portfolios.

Octagon’s Gretchen Lam noted that for equity and debt investors, what is most important from CLO managers is not how they manage defaults or tiple-Cs (even if these are important), but rather how they manage losses. “This is an underappreciated dynamic”, she said, adding that what investors want to know is what the recoveries are going to be.

Investors appear to be keen to see CLO managers being pro-active. Investors on the panel "Clash of the Titans: CLO Debt vs Equity" said they wanted managers with convictions. One said he expects CLO managers to have doubts, rethink their strategies and even be "neurotic".

Middle Market
The “Mind on the Middle: Exploring the Middle Market & Private Credit Opportunity” panel touched on a range of issues, in particular the impact on securitisation of private debt’s continued growth, the rising likelihood of defaults in portfolios and the emergence of recurring revenue deals.

Sean Malone, managing director at KBRA, said activity in the middle market CLO space has grown notably in recent years, and that he sees significant ongoing tailwinds for issuance. He pointed to diversity across management platforms, higher risk adjusted returns compared with the BSL CLO market, lower sensitivity to valuation swings and lower correlation with public markets.

Malone said annual activity in the market has risen from US$10bn 10 years ago to US$22bn in 2021. “If you look at what’s been done in the first quarter of 2023, CLOs have already printed close to $7bn,” he said. “It’s obviously a challenging fundraising environment, and it’s hard to say that any new records will be set this year. But by pure extrapolation from Q1, we could see anywhere between US$20bn to US$25bn for the full year, which is high by historical standards.”

Panellists acknowledged that spreads have risen in recent years, with Malone saying the middle market CLO premium is currently high, “at around 50bp to 60bp over BSL CLOs”. Ramki Muthukrishnan, senior director and head of leveraged finance at S&P Global Ratings, said average spreads have risen from 155bp over SOFR in 2021 to 225bp in 2022, while median spreads have risen from around 155bp to 240bp.

“There have been around 155 middle market CLOs issued from 2018 to 2022, almost double the 84 middle market CLOs issued in the five years before that,” said Muthukrishnan. “This growth really mirrors direct lending growth.”

Chris Gilbert, head of US CLO banking at Natixis, said banks have been able to provide some financing to private market portfolios. However, they have faced growing constraints, which have become more acute for regional banks in recent weeks, presenting an opportunity for CLO managers. “There is expectation of continued growth on the capital markets side and it is anticipated to take additional share from the syndicated market.”

Panellists agreed that deal origination activity in private credit has slowed in recent months, as it has in the syndicated loans space. In large part, this is driven by a decrease in exits by private equity houses, with low valuations making them reluctant to sell. This has led to a fall in secondary buyout activity, which typically accounts for a large portion of private equity acquisitions.

Another factor that has contributed is a decrease in fundraising activity by private debt managers since the second half of 2022. Nevertheless, add-on transactions and non-sponsor vendors are still providing a source of deal flow.

Natixis’s Gilbert and S&P’s Muthukrishnan said they expect to see increasing effects of stress on private debt portfolios in the coming months. This is being driven by a rise in borrowing costs and recent high inflation.

S&P has seen default rates for the broadly syndicated loan market rise from 0.25% to 1.35% over the past year, Muthukrishnan said, and the agency forecasts this will touch 2.5% by the end of the year. He said there has also been an increase in selective defaults, where an issuer seeks PIK agreements, rescheduling of principal amortisation, a reduction in interest payments and pushback of impending maturities in order to avoid a general default.

The flexibility of the direct lending model may make the asset class well positioned to weather the storm, Gilbert said. Some managers, when faced with deterioration in a portfolio business, may look to take early action early. This, he said, may mean there will be defaults, but recovery should be significantly higher than in other asset classes.

One area of private debt that has seen significant growth in recent years has been recurring revenue lending. This is where recurring revenue is used instead of EBITDA in leverage and debt service ratios. These loans, which typically target early stage companies, have begun filtering into the securitisation space, panellists said.

KBRA’s Malone said the agency has rated “a handful of recurring revenue securitisations from some of the more prominent market lenders” over the past four years. He added that, despite recent headwinds, most companies in recurring revenue loan portfolios have been able to sustain steady growth.

“We have yet to see material delinquencies or defaults in these portfolios, which is great from a deal performance perspective but doesn’t give us a huge amount of recovery and default data to draw on,” said Malone. “The assumptions we make on these deals tend to be very conservative from a default probability and recovery perspective. Having said that, the structures themselves tend to be very well-levered compared to similarly rated middle market CLOs.”

The growth in recurring revenue lending has been primarily driven by demand from private equity houses, said Natixis’s Gilbert. “When we speak to the subset of direct lenders that are active in the space, they are attracted to it because their sponsors are attracted to it. Capital follows capital, and here the direct lenders are following their sponsor clients.”

Documentation
The last year has not been one of innovation in CLO documentation, according to Joseph Trunzo, principal, head of CLO documentation at Carlyle, speaking on the “What’s up Doc? Documentation Developments” panel.

Trunzo said: “The year 2022-2023 has been more of a trend of getting investors trying to protect the principal and their capital and avoid managers from taking undue risk. One trend I think has made its way to the market in 2022 and has a strong foothold and benefits both debt and equity investors is the concept of the uptier priming facility, which is the asset drop-downs, priming transactions that allow lenders to increase their recovery. So, that to me, has been the largest development/innovation in CLO technology that is the most useful.”

On the contrary, speaking on the same panel, Jeff Burton, director at S&P Global Ratings, notes that when it comes to CLO documentation, uptier priming language is an extra layer of something that already existed.

“It’s not a bad concept but it’s very difficult to see how it’s been incorporated into the documents and potentially leaving some holes in the sense of how these assets are treated and what proceeds are used to purchase them. From our perspective, this is a natural extension of the workout loans and you can argue that it’s been something that’s been permitted throughout, ever since this workout language was incorporated,” he said.

According to Trunzo, the most important aspect is getting that basket and the ability to carry it at par, rather than having to have credit for overcollateralisation purposes.

“It's great not to be in a position where we were 24 months ago, where research from S&P Global shows that if you do not participate or cannot participate in these types of transactions, your recoveries essentially are zero. Hence, why you see this gain in universal acceptance between debt and equity investors. Everybody across the capital stack is interested in maximising recovery, while at the same time minimising risk,” he added.

Additionally, collateral obligation definition is another much-discussed topic, Burton noted.

“Managers are looking for the flexibility they need in order to navigate troubled waters. But the way that the documents are drafted is something that we are constantly looking at,” he concluded.

Claudia Lewis, Mark Pelham, Jean-Marc Poilpré, Corinne Smith, Ramla Soni, Kenny Wastell

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